We talked to Morgan Stanley's head of media research about Netflix, Disney, and cord-cutting

When Ben Swinburne joined Morgan Stanley's equity research team
in 1999, companies like Netflix, Amazon, Facebook and Google were
in their infancy, if they existed at all.

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Now, 18 years later, they're some of the most highly valued
equities on stock markets.

We spoke with Swinburne, now a managing director and head of
media research at the bank, about how cord-cutting and the rise
of streaming are affecting all companies, from legacy cable
providers like Altice
to movie studios like Disney.

Here's what Swinburne says to expect this earnings season from
Netflix,
Disney, Pandora,
and the other 29 companies he covers.

This interview has been edited for clarity and length.

Graham Rapier: What's on your radar as we
approach earnings season?

Ben Swinburne: We're seeing an acceleration in
consumer adoption of over-the-top content. That's showing up in a
lot of different places. We're seeing significant growth in
network usage, both wireless and wired, which is obviously
helping the cable industry and leading the charge in terms of
taking share in broadband business. We think it will also help
drive value for DISH's
stock because Dish owns a unique portfolio of spectrum assets.

And then on the content side, there are clearly businesses
benefiting from that shift, Netflix
being the most obvious. But there are other companies who either
own unique intellectual property, like MSG, who own the Knicks
and Rangers, where we're seeing the value of that unique IP grow
in a market where you have more and more money funneling into
over-the-top and trying to reach consumers.

Even on the traditional network side, there are businesses that
clearly have some challenges but have really exciting
opportunities in that shift. One of those names we tend to talk
about is Lionsgate, which owns Starz. Starz and its fellow
premium network, like HBO and Showtime, they've all typically
always been sold at the top end of a pay-TV package that can run
$80 to $120 per month. They're now able to reach the consumer and
broadband-only homes in a way that they weren't before, so that's
quite exciting. There are traditional companies that have easier
and more challenging tidbits toward this skinnier bundle and OTT
world that we're clearly moving toward even faster this year.

Rapier: You mentioned Netflix specifically. What
will you be watching in its earnings report next week?

Swinburne: Obviously they're going to report
subscriber results and guide to the fourth quarter, so that'll be
a big focus. Longer term, we really believe the company has
significant profit potential, and they're just starting to
generate earnings today. We believe there's a path to significant
margin for this business. The cost structure is largely fixed,
and what I mean by that is there's no relationship really between
how many customers they have, how much revenue they generate, and
how much they're spending, particularly on content. To the extent
that they can drive pricing or customer growth that will
translate into greater and greater margin over time. So the fact
that they've introduced some new price increases recently tells
you that their path toward profitability is improving and
accelerating more than the market has previously realized.

Rapier: Most of Netflix's growth in recent
quarters has come from abroad while the US subscriber growth has
decelerated. How do you see this playing out?

Swinburne: The US market is obviously the one
where they've got furthest along in terms of penetration, but
they've done really well in international markets as well, so I
think the international opportunity is certainly significant. On
the US side, there are 80 million paid TV households in the
United States and a roughly similar number of broadband homes, so
there is certainly room for Netflix to grow.

There are 80 million paid TV households in the United States and
a roughly similar number of broadband homes, so there is
certainly more room for Netflix to grow.

What I think Netflix is doing around distribution is quite smart.
They have an agreement with T-Mobile, for example. They have an
agreement with Comcast on the X1. So when you look at 2 hours or
more of viewing a day in a Netflix home, that level of engagement
would suggest this can be a fairly widely adopted, if not mass
market product, in the United States.

What they've proved is that the model can be replicated in other
markets. I'm not sure they'll get to US penetration and US
profits in every market - there are markets that culturally don't
watch as much television as we do and don't spend as much money
as we do. I'm not sure that's going to dramatically change, but
Netflix may be serving these markets in a way they haven't been
served before from a product perspective.

The history would tell you that the company, if given time, can
ramp in almost any kind of market. It's probably intuitive that a
market with a relatively developed economy like the US and the
UK, and certainly English language with a strong technology
adoption curve, strong broadband networks, would be a successful
one for Netflix.

Then you look at a market like Brazil - obviously an emerging
market, with a much different income per capita, a much weaker
broadband-network structure than what you typically see
elsewhere, and the product has scaled to profitability and
significant penetration rates that should give people confidence
that they can scale in other kinds of markets.

caption

Netflix is planning to spend $6 billion on original content in 2017.

source

Netflix

Rapier: Will competing platforms eat into
Netflix's potential market? Will they be successful on their own?

Swinburne: Over time you'll see more
direct-to-consumer strategies come out of traditional TV
businesses that have been wholesaled. You'll see studios - who
also compete with Netflix - be very careful in licensing to
Netflix. What Netflix has proven out so far is they have a nice
strategy to hedge that risk.

For one, they've vertically integrated and are producing a lot of
their new programming themselves. That also includes hiring
showrunners who are exclusive to Netflix, like the
Shonda Rhimes deal that was announced recently. They're
attracting talent to their platform, and between their checkbook
size and their global scale and subscribers, it's a unique place
to go make TV shows and movies for.

The other piece is that when most traditional television studios
make a show or produce a film, there are equity participants in
those assets. Specific producers or directors may own equity in
that show, and it's very important that that talent is happy with
how the product is monetized and distributed. So if Netflix is
the best place, financially and otherwise, for that show to end
up, that's what will happen more often than not.

Rapier: What about Disney?
Can its standalone service compete? What are you looking for in
Disney's earnings on November 9?

Swinburne: On this next earnings call we'll get
greater clarity on the near-term impact to earnings from this
shift toward over-the-top. The biggest dilution in 2018 will
probably come from their BAM tech acquisition, which closed in
September. You'll start to see some licensing revenue go away
because they will be pulling products back for themselves. We'll
get a little more clarity on the impact of all that on the 2018
financials when they report. That obviously will be a big focus
for people.

Bigger picture, though, what we have seen in the past several
years is that there's tremendous demand for over-the-top content.
It's not just Netflix, Amazon,
and Hulu. We've seen lots of other services, traditional services
like Starz or CBS All-Access, but also niche services like
Japanese anime from Crunchyroll scale to 1 million-plus
subscribers relatively quickly in a market that's very early.

Then we have these virtual MVPDs [multichannel video programming
distributors], whether it's YouTube TV or Sling, that we think
are going to reach 4 million subscribers by the end of this year.
People are adopting and watching more than ever. When you think
about Disney's brands - Disney, Pixar, Star Wars, Marvel -
they've got a better chance than probably any other existing
content and media company to take advantage of all this.

Now, that will take time, and it will take some initial
investment, but we think particularly on the kids side and how
important OTT is to kids viewing and families, there's a huge
opportunity for them globally in a direct-to-consumer Disney
environment. That's different for ESPN, but certainly for the
Disney side of the house, the outlook long term is quite bullish.

Rapier: What's different with ESPN? What will
you be watching for in that business segment?

Swinburne: Our eyes are all wide open. ESPN has
probably benefited more than any other business in the existing
bundle, from a profit perspective. They are facing a market where
skinny bundles are the future, so they have to figure out a way
to run their business in that environment. The good news there is
that they are aware of these challenges. They are moving to an
over-the-top product in 2018 that will give them a lot of insight
into how sports can work - or not - in an OTT environment, which
will inform them quite a bit in how they think about bidding for
sports rights in three or four years, when the NFL, baseball, and
other big sports deals are up.

The last piece would be that they just had a very successful
renewal with Altice, the first distributor renewal in an upcoming
cycle and very important to driving the earnings for that
particular business in Disney going forward. I think investors
should take some confidence out of the Altice renewal that the
Disney portfolio of networks - which is not just ESPN but also
ABC, Disney Channel - remain incredibly important assets in a
competitive cable world.

Rapier: What's going on in the cable industry?
Is there any upside potential in those service providers?

Swinburne: Absolutely. Whether you're talking
about a Disney
or Lionsgate,
they certainly have value in this new ecosystem. Their content is
being consumed at generally higher levels than before and there's
a clear path at least for some of these businesses to build new
profit pools in an OTT environment.

On the cable-specific side, Comcast
and Charter
are two stocks we like. The fact that they are cable businesses
is almost a misnomer today. They're really ISPs.

The fact that they are cable businesses is almost a misnomer
today. They're really ISPs.

Every cable operator has more broadband customers than video
customers today. The earnings contribution from broadband is
growing rapidly, while the earnings contribution from video is
declining. Their exposure to television and cord-cutting is
probably a lot lower than people realize. You'll see the number
of devices people have in the home, the data they're consuming,
has been growing 30%, 40%, 50% year-on-year, a trend that's going
to continue. That really plays to the cable industry's strengths.

Rapier: Is there any competition to these
incumbent service providers? Is Google Fiber or something like
that even on their radar?

Swinburne: They really have a unique product
position in the marketplace; they've got the best mousetrap. The
cable plant is the most flexible plant in adding capacity
inexpensively, where they compete with twisted pair, DSL, they
offer much faster speeds. It's incredibly expensive to build a
scaled fiber business across the United States. Google Fiber has
essentially stopped adding any new footprint.

Rapier: What haven't we talked about that's on
your radar?

Swinburne: We're quite bullish on the music
business. There are not a lot of ways to play that in the public
markets today. We have an overweight on Pandora;
we think they are in a position to disrupt and take share from
the traditional radio market from an advertising perspective.
That's a part of media that, after 15 years of declines in
spending, has really started to take off with growth in
subscription streaming. We think it's a business that's going to
grow rapidly for a long time.